Effect of shipping costs

Question

Assume that pound is being pegged to the gold at 6 pounds per ounce; on the other hand the franc is being pegged to the gold at 12 francs per ounce. Which, of course, states that equilibrium exchange rate must be the two francs per pound? If existing market exchange rate is 2.2 francs per pound, how you would take benefit of this condition? Explain about the effect of the shipping costs?

Answer 1

Assume that you required buying 6 pounds by using the French francs. If you will buy 6 pounds directly in foreign exchange market, it can cost you 13.2 francs. Otherwise, first you can buy an ounce of gold for 12 francs in France and then ship it to the England and sell it for the 6 pounds. Now, it will only cost you the 12 francs in order to buy 6 pounds. It is therefore valuable to ship gold as a result of the overpricing of the pound. Evidently, you may have an arbitrage profit by selling the 6 pounds for 13.2 francs in foreign exchange market. Arbitrage profit can be 1.2 francs. Up till, we have assumed that the shipping costs don’t exist. In case, it costs more than 1.2 francs to ship an ounce of gold, there may be no arbitrage profit.